Preference shares make less noise than their boisterous cousin, ordinary shares. So, if you believe in peaceful coexistence, owning preference shares may be a good choice. But let us first find out what makes preference shares different from equity and bonds. Maybe Jinny and Johnny can help us.

Jinny: Hi, Johnny! Why are you so silent today?

Johnny: Something has been bothering me for a while.

Jinny:
You can always share your thoughts with me.

Johnny: I was wondering how preference shares manage to slip in between the worlds of equity and bonds without making any noise.

Jinny: Preference shares, as the name suggests, are special kinds of shares. The holders of these shares enjoy fixed dividends on the profits of the firm. However, they do not enjoy voting rights like ordinary shareholders.

Illustration: Jayachandran / Mint

The payment of fixed dividends and absence of voting rights make preference shares look like debt instruments. But in the balance sheet of the firm, they are counted along with ordinary shares as equity of the firm. So, preference shares are part of the equity family although they are treated as first among equals when it comes to the dividend.

Ordinary shareholders have no special right to receive any dividend, though they enjoy full voting rights. They can receive dividend from the profit only after satisfying the claims of preference shareholders. Even then, the decision to pay dividend to ordinary shareholders rests entirely on the discretion of the firm. Even if the firm has surplus profit after paying preference shareholders, ordinary shareholders may not get any dividends if the firm decides to redeploy the profits for some other use. Preference shareholders, on the other hand, will continue to have an uninterrupted feast as long as the table is full.

Johnny: What if the firm isn’t making profits? How will it affect preference shareholders?

Jinny: The firm not making profits affects different kinds of preference shares differently. In the case of cumulative preference shares, all unpaid dividends get accumulated and have to be repaid in subsequent years. In the case of non-cumulative preference shares, any unpaid dividend in the year lapses thereafter, and the firm is under no obligation to repay past dividends out of future profits. In case dividends remain unpaid for a certain number of years, both cumulative and non-cumulative preference shareholders get voting rights. Here, you may notice the difference between a preference share and a debt instrument. Interest payments on all debt instruments have to be compulsorily made by the firm from its earnings before declaring profit. If it fails to do so, its creditors may start procedures for bankruptcy.

Johnny: What is the status of preference shareholders in case the firm goes bankrupt?

Jinny: In case of bankruptcy, preference shareholders have a better claim than ordinary shareholders. But, their claim is not as good as that of secured and unsecured creditors. Any assets of the firm in case of bankruptcy will be first used for meeting the claims of secured and unsecured creditors. Any surplus remaining will then go to preference shareholders. Ordinary shareholders are the last to get whatever is left on the table.

Johnny: Last to get dividend, last to get assets. Then what is the advantage of subscribing to ordinary shares?

Jinny: Ordinary shareholders enjoy capital appreciation on their investments, which neither creditors nor preference shareholders do. If the firm discovers a gold mine, the ordinary shareholders would be the ones taking home capital appreciation. An ordinary share of Rs10 face value listed on a stock exchange may appreciate to Rs100, giving 10 times appreciation of value to its owner.

Preference shares are not listed on the stock exchange, and so you may not hear much about their existence. Preference shareholders and creditors have to remain satisfied with whatever dividend or interest they are earning on their investment. When you’ve purchased tickets for a limited meal, you should not feel jealous when your neighbour is having an unlimited feast.

Johnny: What else do I need to know about preference shares?

Jinny: There are a few more things: A redeemable preference share can be redeemed at its face value after a certain number of years at the option of the firm. A convertible preference share can be converted into ordinary shares after a few years at a predetermined price. Now, that sounds fantastic. You can enjoy fixed income for a few years and then enjoy all the fun of ordinary shares that you’d missed before. There is another class of preference shares—participating preference shares—in which, apart from getting fixed dividend, you also get the opportunity of getting additional divided if ordinary shareholders receive dividend above a stated amount.

Johnny: That sounds great. It is always better to have a second serving at a feast.

What:Preference shareholders enjoy fixed dividend but no voting rights.When: In case dividend remains unpaid for a certain number of years, both cumulative and non-cumulative preference shareholders get voting rights.Who: Preference shareholders have a better claim than ordinary shareholders on the assets of the company in case the company goes bankrupt.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com